Fed expected to lower rates despite raging inflation

WASHINGTON (MarketWatch) -- In a glorious bit of timing, the Federal Reserve is expected to cut interest rates on Tuesday for a third straight meeting, just days before government data are released showing some of the highest inflation rates in decades.

That's all you need to know about the Fed's balance of risks: Policymakers are much more worried about the illiquid credit markets and the possible hit that the credit squeeze could have on the economy than they are about the risks of inflation breaking out.

"Don't look now, but while we're in the midst of an easing cycle, the U.S. is facing a 4% inflation rate," wrote Avery Shenfeld, an economist for CIBC World Markets. "But for now, none of this matters, as both bonds and the Fed are focused on the credit crunch and its growth threat."

The economic data have been weak, but not disastrous, since October's meeting, when the Fed signaled that it thought it was done cutting rates. It's not the immediate economic situation that's brought the Fed back into the game of cutting rates, it's the horrendous condition in the credit markets, which are arguably worse off now than they were in August.

"The Fed is expected to reduce rates in response to evidence of very sluggish fourth quarter growth, and further stresses in the credit markets," wrote Brian Bethune and Nigel Gault, U.S. economist for Global Insight.

Ahead of the relatively strong employment report on Friday, markets were anticipating that the Federal Open Market Committee could cut the federal funds target rate by a half percentage point to 4%. Now it seems more likely to be a quarter-point cut, especially considering the strong minority opposition within the committee about cutting at all.

Many economists are reviving their forecast that the Fed will do something dramatic with the discount rate, a tool for providing liquidity to banks that's been underutilized in the Fed's view. The Fed could cut the discount rate by 50 basis points, further reducing the penalty spread between the federal funds rate and the discount rate to just a quarter point.

The economic data to be released in the coming week should continue the theme of weak growth and rising prices. It will comfort some (and outrage others) to note that core inflation is expected to remain within the Fed's guidelines.

The biggest numbers will come late in the week, long after the Fed's decision. The consumer price index will be released on Friday, as will the industrial production report. Retail sales and the producer price index will be released on Thursday. The import price index comes out Wednesday.

Higher energy prices in November will drive all the inflation numbers higher. The CPI is expected to rise 0.7%, according to the median forecast of economists surveyed by MarketWatch. See Economic Calendar.

Other than that one month in 2005 right after Hurricane Katrina smashed the petroleum industry, that'd be the highest monthly inflation rate since the early 1990s. The PPI is expected to jump 1.6%, also one of the highest figures ever recorded. Import prices probably jumped 2%.

Markets and the Fed will probably brush off the worrisome inflation news. For one thing, gasoline prices have settled down since the big run up in late October and early November. And core inflation should be comfortably low, probably rising just 0.2% for both the PPI and CPI.

"We see little price pressure at this time," wrote economists for Citigroup Global Markets. "We do not anticipate that higher energy costs will be passed through to underlying inflation."

In fact, higher energy prices (and a slowing economy) will probably lead to less demand for other goods, Citigroup said, which would put downward pressure on core prices.

The higher cost of gasoline will boost retail sales for November, economists said. They expect nominal retail sales rose about 0.6% after a tepid 0.2% gain in October. Excluding autos, sales probably rose 0.7%, which sounds pretty good until you factor in the inflation rate.

The holiday sales season got off to a "solid start," economists at Wachovia said. Still, real consumer spending has slowed at a 1.5% pace in the fourth quarter, only about half the growth of the third quarter, said Peter Kretzmer, an economist for Bank of America.

The other numbers

Industrial production probably increased 0.2% in November after a 0.5% drop in October. Some of the improvement is simply a matter of more seasonably cold weather boosting utility output after a warmish October. But growth in exports is also pushing manufacturing output higher.

The trade gap is expected to widen slightly in October to $57 billion from $56.5 billion, largely because of oil, economists say.

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